The danger in Europe's culture war

SimonNixon

At the heart of the euro crisis has been a culture war, played out within states as well as between them. This culture war has now reached a decisive phase. Over the coming weeks and months, the outcome will become clear and the consequences could be far-reaching.

The division is between a private-sector culture which believes that sustainable growth depends on exports and investment and therefore emphasizes policies to deliver open and competitive markets and flexible workforces; and a public-sector and trade-union culture which believes growth depends on putting more money in people's pockets and so favors Keynesian demand-side policies to boost government spending and encourage borrowing, and to protect jobs and raise wages.

Both cultures exist within every country. But it is striking that those countries where the private-sector culture is dominant are currently delivering the strongest growth.

Ireland, for example, is enjoying a remarkable recovery: Its economy is forecast to grow 1.7% this year and 3% next year, and bank lending and house prices are now rising again. Similarly, the U.K. is likely to grow by 3.1% this year and unemployment has fallen to 6.8%. Germany's impressive performance over the past five years reflects tough reforms of public spending and the labor market in the previous decade. The Baltic states are delivering strong growth.

In contrast, those countries where the public-sector culture is dominant are the ones where growth is slowest. France has world-class companies, a strong industrial base, and high productivity. But successive governments have been unable to halt the loss of competitiveness caused by excessive tax and public spending, rigid labor and product markets, and high relative wages.

Italy suffers from similar problems, with the added burden of a dysfunctional public administration, a creaking judicial system and high levels of corruption and tax avoidance. These two countries, which account for almost half of euro-zone gross domestic product, are forecast to grow this year by just 1% and 0.6% respectively, hurting the prospects of the entire currency bloc.

Nonetheless, the crisis has forced most governments to undertake supply-side reforms--even those where the public-sector culture is traditionally dominant. That's because there has been little demand-side alternative: Most countries are too indebted to pursue expansionary fiscal policies and are anyway bound by tough euro-zone rules; nor have they been able to force the European Central Bank to pursue more expansionary monetary policies.

Indeed, those crisis countries that have made most progress with reforms are now seeing the benefits. In Spain, Portugal and Greece, which have all taken significant steps to make labor and product markets more flexible, growth this year could hit 1.1%, 1.2% and 0.6%, respectively, helped by rising exports and falling prices, which have helped boost household spending power. This recovery has eased fears over debt sustainability and the survival of the euro, leading to a collapse in government bond yields that has further boosted confidence. A virtuous circle. Even France and Italy now have new governments committed to reform.

But it is too soon to declare the triumph of the supply-siders; there are signs of reform fatigue in many countries and recent events show the public-sector culture is fighting back.

Take Portugal, where the Constitutional Court last week sided with the opposition to again frustrate the government's efforts to cut the cost of public administration, suggesting taxes should rise instead. European Union officials fear that this risks descending into a damaging standoff that could lead to political instability just as Portugal is exiting its bailout program.

Or Greece, where the government last week effectively fired the head of the independent tax administration. Athens insists this reflected concerns about competence following a series of misjudgments. But EU officials suspect political interference--indeed his biggest missteps appear to have been overzealous investigation of pensioners and blocking tax breaks for policemen during an election campaign. That is worrying because the credibility of Greece's institutions is essential to attract vital foreign investment.

Even Spain's commitment to reforms is increasingly questioned: What has been missing is any serious effort to overhaul its complex system of public administration, which continues to be an impediment to the delivery of its reforms and a drag on the public finances. With elections due in 2015, Spanish business leaders fear the window for fresh reform is closing.

As for the French and Italian reform programs, these so far look more rhetorical than real.

The International Monetary Fund last week criticized France for a lack of detail in its proposed spending cuts; a large proportion appear to be simply wage freezes with only 27,000 jobs to go from the public administration. In Italy, Prime Minister Matteo Renzi's program appears to have run into the sand. A much-hyped labor-market reform was watered down. It remains to be seen whether his party's success in the European elections revitalizes Mr. Renzi's efforts.

This matters because if the euro zone's reform momentum is lost and the recovery falters, the pressure for a demand-side response will grow. Yet the euro zone is ill-equipped to deliver such a response without profound changes to the rules of engagement and therefore to the nature of the currency union itself. These tensions lie at the heart of the two biggest debates on its agenda.

The row over who should lead the European Commission, the EU's executive arm, pitches those who believe that the EU should be an association of self-governing nation states against those who believe the EU should evolve into a federal system with greater scope to pursue more expansionary fiscal policies. Both France and Italy have said they would campaign for the new commission to relax the EU's budget rules.

Similarly, the debate over the ECB's response to low euro-zone inflation pitches those who believe the ECB should engage in money printing against those who believe the ECB shouldn't assume the debts of member states.

Last week, the ECB announced a package of measures that sounded impressive but in reality were designed to buy time, in the hope that reforms will ultimately deliver sufficient growth to relieve it of the burden of taking sides.

How these situations play out could determine who ultimately wins Europe's culture wars.

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